Asset allocation is an important part of the portfolio management process. It is a function of an investor's investment horizon, risk tolerance level and investment capital. Sometimes, however, extreme market conditions could prompt investors to deviate from their desired asset allocation. And indeed, investors should take advantage of such market conditions to tilt their portfolios. The question is: How should investors' engage in portfolio tilts?

This article defines strategic asset allocation. It then shows how investors can engage in portfolio tilts to take advantage of short-term asset price movements. Such strategic tilts embrace the core-satellite portfolio framework.

As the initial step in the portfolio creation process, investors decide their exposure to stocks, bonds, real estate and other alternative asset classes such as commodities. The strategic asset allocation (SAA) is a long-run allocation based on the desired investment objective.

Consider an investor's retirement portfolio. Suppose the SAA is 40-55 per cent in equity, 40-50 per cent in bonds and 5-20 per cent in commodities. There are two reasons why it is preferable to define SAA as a range. One, an exact proportion, say 55 per cent to equity, would require the portfolio to be rebalanced frequently to align with the SAA because of the continual change in asset prices. This could be inefficient due to high transaction costs and tax incidence. Two, the range enables investors to take advantage of sharp changes in asset prices.

The short-term deviation from SAA to take advantage of asset mispricing is called strategy tilts. The question is: What are the characteristics of such strategy?

Investors can engage in two kinds of strategy tilts. One, the investor can tilt the portfolio towards equity or bonds. We call this Strategy Asset Class Tilt. Two, the investor can tilt towards a style within an asset class (say, large-cap to mid-cap). We call this Strategy Style Tilt.

Suppose an investor believes that there has been extreme price movement in the equity market and expects price correction within the next year, she has to first confirm her belief using either technical analysis or quantitative modelling. We believe that either of these forms of analysis would be useful because Strategy Tilts are essentially mean-reverting strategies.

That is, an investor should tilt the portfolio only if she believes that there has been extreme price movement in an asset class (Strategy Asset Class Tilt) or within an asset class (Strategy Style Tilt). A classic example of a Strategy Tilt is the equity tilt in 2008 when pessimism was high in the market due to the sub-prime crisis.

The next question is: How to set-up such strategy tilts?

Investors should have a robust model to indicate extreme price movements. The model should also capture the likelihood of mean reversion in asset prices. A technical analyst would use weekly charts to identify extreme price movements and likely turns in S&P CNX 500 for asset class tilts and CNX Mid-cap and Nifty for style tilts. A quantitative analyst would apply mean-reversion models to set-up such strategies. It would be rather tedious but not impossible to apply fundamental analysis for such strategies. Investors should have a process to define exit rule for each strategy tilt; for untimely exit leads to sub-optimal returns.

It is important to note that strategy tilt is technically different from tactical allocation. Strategy tilt bets on mean reversion due to extreme price movements. Tactical allocation can be set-up for smaller non-mean-reverting price changes, either among styles within an asset class (Tactical Style Allocation) or between two asset classes (Tactical Asset Allocation).

Conclusion

Strategy tilts are high conviction strategies. But the market will not offer such extreme price movements frequently. If they do, such price movements cannot be termed “extreme”. Such strategies fit nicely inside a satellite portfolio within the core-satellite framework. Care should be taken to manage the risks associated with such tilts, lest they harm the core portfolio's ability to achieve the desired investment objective at the horizon.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at >enhancek@gmail.com )

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